IASB February 2006

The Board continued its discussion of the following approaches it is exploring for insurance contracts:

• - For non-life insurance pre-claims liabilities (ie the stand-ready obligation to pay valid claims for future insured events arising under existing contracts): either an unearned premium approach, or a prospective approach. The unearned premium approach measures pre-claims liabilities by reference to the unexpired portion of the consideration received. The prospective approach measures them by reference to future cash flows.
• - For non-life insurance claims liabilities (ie liabilities to pay valid claims for insured claims that have already occurred) and for life insurance liabilities: a prospective approach (either current entry value or current exit value).

The Board discussed the following:

• - Contractual cash flows that depend on policyholder behaviour
• - Acquisition costs
• - Liability adequacy test
• - Gain on initial recognition
• - Measurement attribute for non-life pre-claims liability.

Contractual cash flows that depend on policyholder behaviour

For many insurance contracts, cash flows depend on whether policyholders exercise contractual options. For example, policyholders often have a contractual right to cancel a contract. The Board decided that:

When an insurer recognises rights and obligations arising under an insurance contract, it should also recognise as an asset the portion of the customer relationship (relationship with the policyholder) that relates to future payments that the policyholder must make to retain a right to guaranteed continued coverage without reconfirmation of the policyholder’s risk profile, at a price that is contractually constrained. 􀂄 The staff should investigate whether an insurer should present or disclose that customer relationship separately from its other rights and obligations.

Acquisition costs

The Board discussed acquisition costs (the costs that insurers incur to sell, underwrite, and initiate a new insurance contract). The Board reached the following conclusions in the context of a current entry value model or an unearned premium model:

• - If an insurer has already recovered relevant acquisition costs from premiums received, the insurer should exclude that portion of the premiums from the measurement of the insurance liability.
• - If an insurer expects to recover relevant acquisition costs from future cash flows under existing contracts, the insurer should consider that portion of those cash flows in measuring the portion of the customer relationship that relates to those contracts.
• - Acquisition costs should not be deferred and presented as if they were an asset.

The amount of such an asset would have no independent meaning, and any method of amortisation would be arbitrary. The Board also concluded that acquisition costs play no direct role in a current exit value model, but they might play an indirect role as one piece of evidence that might help to corroborate estimates of the price that market participants might be prepared to receive (or pay) for the insurer’s contractual rights and contractual obligations and for the portion of the customer relationship that relates to the existing contract. The Board discussed how to define relevant acquisition costs, but the staff did not ask the Board to reach a conclusion on this topic. If necessary, the staff will ask the Board to discuss this again at a future meeting. A future meeting will also discuss how to present acquisition cost expense at inception.

Liability adequacy test

A liability adequacy test is intended to determine whether the carrying amount of a liability needs to be increased (the test is similar to an impairment test, which tests whether the carrying amount of an asset needs to be decreased). The Board concluded that:

• - A liability adequacy test is needed in the unearned premium and current entry value approaches, but not in a current exit value approach. For the current entry value approach, the Board will assess at a future meeting whether such a test is needed only at inception or also subsequently.
• - The margin for a liability adequacy test should be consistent with the margin that would be included in current exit value.
• - If the liability adequacy test identifies a shortfall, an insurer should subsequently recognise income as it is released from the risk represented by the margins included in that shortfall (for both an unearned premium approach and a current entry value approach). The insurer should accrue interest on the shortfall in a current entry value approach, but not in an unearned premium approach. However, when interest is not added, an additional shortfall may arise later when the liability adequacy test is applied again. If a shortfall no longer exists, the insurer should reverse it.

At a future meeting, the Board will discuss:

• - the unit of account for liability adequacy tests. 􀂄 whether a liability adequacy test should be net of reinsurance or gross.
• - the income statement presentation of shortfalls and of subsequent related income and expense (release from risk, interest, reversals).

Gain on initial recognition

The Board discussed whether an accounting model for insurance contracts should prohibit the recognition of a gain at inception of an insurance contract. Although some Board members expressed a preference for not including such a prohibition, because the answer to this question provides the main distinction between the current entry value approach and the current exit value approach, the staff did not ask the Board to reach a conclusion on this topic. The staff plan to ask for a decision when they ask the Board to choose between those two approaches.

Measurement attribute for pre-claims liabilities

In May 2005, the Board directed the staff to work in parallel on two alternative approaches for non-life insurance pre-claims liabilities, until the Board determines how to select one of them. At this meeting the Board:

• - decided to adopt a prospective approach for those liabilities (either current entry value or current exit value). The staff expect to ask the Board in April to express a preference between current exit value and current entry value.
• - noted that insurers may be able to develop reasonable approximations to a prospective measurement. For example, unearned premium might sometimes provide such an approximation if the pattern of risk is linear, the contract is not likely to be highly profitable or highly unprofitable, and circumstances have not changed significantly since inception. The staff will investigate whether the Board should develop guidance on such approximations.
• - confirmed one point that was implicit in earlier discussion: the discount rate for non-life insurance claims liabilities should be current.

The Board plans to address some other matters relating to discount rates at a future meeting. The Board plans to discuss at a future meeting:

• - how an insurer should report premiums and claims information in a prospective approach.
• - whether an insurer should accrue interest on pre-claims liabilities and account separately for the release from the risk embodied in measurements of pre-claims liabilities.

Next steps

The Board expects to continue its discussion of the main components of accounting models for insurance contracts in March.